What's the Difference Between Gambling and Trading Again?

Bad news for gamblers: The shuttering of InTrade leaves you only the stock market, futures markets, casinos, and other predictive markets on which to blow your time, your money, or both. Assuming, of course, that you understand the difference between all of those things. If you don't, we're here to help.

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Bad news for gamblers: The shuttering of InTrade leaves you only the stock market, futures markets, casinos, and other predictive markets on which to blow your time, your money, or both. Assuming, of course, that you understand the difference between all of those things. If you don't, we're here to help.

At first glance, it's not entirely clear why InTrade shut its doors. Or, rather, it's not clear why Americans were kicked out of the marketplace last year; the reference to "financial irregularities" in the company's final statement suggests that there may have been extenuating circumstances. But why did InTrade get the boot while, say, Americans could still invest in the stock market? Or in corn futures? Or head to Atlantic City and bet on the Ravens to win the Super Bowl?

First, some definitions.

You're almost certainly familiar with the stock market, a regulated marketplace in which individuals (and others) trade small pieces of the ownership of companies. While a stock market is based on speculation — on the idea that company value will rise and along with it the value of the share of stock — taking ownership of a share of stock means taking immediate ownership over that (very, very small) piece of the company.

Futures are much more speculative. A future is a type of derivative, a regulated contract between two parties tied to some economic event. (For the sake of simplicity, we'll use futures as the case example for derivatives in this article.) Buying a futures contract usually means committing to buying a good or commodity at a future point in time. Buy a contract for corn prices in May, and you theoretically agree to buy corn in May at a set price. The majority of futures speculators are less interested in owning a bunch of corn than they are in hoping that the price at which they bought the contract will be much lower than the price of corn in May. If that happens, people who do want the corn can agree to buy it from the contract-holder — at the new higher price.

Predictions markets are similar to futures markets, except in what they offer for speculators. Predictions markets don't create a contract to assume possession of a good; rather, they are pure speculation. Convinced that polls are underestimating your candidate's chances of being elected president? A prediction market will let you bet on his chances at a certain dollar amount. If the polls suddenly shift, the price of placing a bet on him will rise. On Election Day, if that price is more than you paid, you'll make a profit — whether or not he wins. (Though if he doesn't win, that price will plummet pretty fast.)

And then there's gambling. Like Galloping Gert in the fourth race at Aqueduct? Pay your money; take your chances.

If you noticed a spectrum in that presentation, there's a good reason for that. The line between each — particularly the latter three — is blurry. As economist Justin Wolfers, who worked for bookies as a boy back in his native Australia, told WGBH Boston last year: "Conceptually, to an economist, there's not a difference between betting and trading — apart from the fact that one sounds more polite than the other."

Erik Snowberg, professor of economics and political science at the California Institute of Technology and occasional collaborator with Wolfers, likewise isn't surprised that there's confusion in the differentiation. "The lines are obviously fuzzy," he suggested when we spoke earlier today. "Even the language that people use is the same." People investing in the futures market say they're taking a bet on a commodity. People betting on the Ravens in Vegas say they're taking a position on the team.

What differentiates between them comes down to one thing: The law. One key (but not universal) distinction between prediction markets and gambling, for example, is that most of the former don't operate using real money, sometimes instead offering prizes for those whose fake-money bets do the best. That's a subtle legal distinction. And the law comes down to a decent amount of subjectivity, no small amount of lobbying, and two somewhat opaque standards. Snowberg explains that legal lines largely depend on the social value of what's being traded.

"One of them is providing liquidity or hedging," Snowberg explained, admitting that hedging had gotten a bit of a black eye during the 2008 economic crisis, thanks to banks' hyperactive efforts to limit the fallout from bad mortgage lending. But in other, less global-economy-destroying ways, hedging provides a safety net for the economy. Lock in a futures price on oil, and companies can better plan for future operations with set costs.

The second social value? If the market provides information. "The public may not see the value," Snowberg suggests, "but … most economists feel the value of the information provided by predictions markets is strong enough that they should be allowed." This is a key point at which subjectivity enters the equation. While predictive markets don't allow for hedging, since there's nothing besides money tied to the bet, they someday could.

In fact, the reason InTrade was banned in the United States is because it began to cross the line between the two. As the Financial Times notes:

InTrade is structured as a series of futures markets, and allows participants (who might equally easily be called gamblers or investors) to stake bets on the likelihood of different outcomes taking place. When applied to sports results, this is in practice a form of spread betting. When applied to securities markets, it appears to have come too close to being a fully fledged futures exchange for regulators to swallow.

Slate's Matt Yglesias explained the decision-making process when the Commodity Futures Trading Commission ruled against InTrade last year because the site was allowing trades on traditional commodities.

[W]hen InTrade goes and launches contracts on the price of oil and gold, then they're clearly crossing that line. This is futures speculation, there's a legal way to do it, and what InTrade is doing isn't that legal way. … It looks like an oil futures contract and it quacks like an oil futures contract, so they're not going to let it happen just because you phrase it as a "prediction market."

But it's not that simple. The "legal way" requires that commodities be regulated by the CFTC — regulation that, according to Snowberg, InTrade sought for years. As early as 2005, Tradesports (InTrade's previous iteration) sought CFTC approval; the creation of independent InTrade was meant to satisfy the CFTC's requirements. It didn't work. While the commodities trades weren't the only reason the CFTC shut down American InTrade activity, it was a primary component.

Snowberg is clearly a prediction markets hawk. He suspects that the lines between futures trading and predictions trading will probably be crossed not in the prediction-to-futures direction, as InTrade attempted, but in the other direction, backed by large financial institutions. "Once a bank sees some sort of value, that they can make a big profit," he thinks, "absolutely it will become a thing." And if the banks get involved, Snowberg worries, the market will lose transparency in the banks' bid to turn a profit.

As The Economist noted last year, it's been tried.

[T]he 2010 Dodd-Frank financial reform gave the [CFTC] broad new powers to regulate prediction markets “in the public interest”. This April it rejected a request by Nadex, a Chicago-based derivatives exchange, to offer contracts on the elections.

The introduction of Dodd-Frank suggests one way the line between futures markets and predictive markets might be erased: political power. What Nadex and Ireland-based InTrade lack in Capitol Hill clout, it's safe to say that Goldman Sachs has in spades.

In 2008, Snowberg, Wolfers, and a number of other economics and legal scholars offered a two-step plan to broaden the use of predictive markets in the United States. The first was to have the CFTC establish clear guidelines for under which prediction markets could safely operate. The second was that Congress should offer its support for the creation of such markets. Perhaps given previous government forays into such markets, the proposal didn't get very far.

But having such innovation driven by the public sector is almost certainly preferable to having it driven by financial companies. There may come a day when you can head down to your broker or off-track-betting parlor and bet on the next Pope, agree to take ownership of 10,000 barrels of oil in June, and put $50 on the Tigers to win the World Series. If that sounds good to you, recognize two caveats. The first is that it would require the retraction of a number of laws meant to prevent risky cross-pollinated economic activity. And, second, that you'd probably be paying your user fees to Bank of America.

This article is from the archive of our partner The Wire.